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Mortgage Debt Forgiveness Excluded from Income

Typically, if you have debt that is forgiven or cancelled, it results in taxable income to you. However there is an exception to this rule for certain mortgage debt forgiven in 2012. Cancelled debt from "qualified principal residence indebtedness" may be excluded from income.

Qualified principal residence indebtedness is mortgage debt taken out to buy, build or substantially improve your main home.

The debt must also be secured by your main home.

The maximum amount of debt that may be excluded is $2 million ($1 million if married filing separate).

The exclusion applies to debt that was reduced through restructuring or cancelled in a foreclosure.

Refinanced debt also qualifies for the exclusion to the extent it was used to buy, build or substantially improve your main home. For example, assume at the time of refinancing that your home is worth $400,000 and you have mortgage debt of $300,000. You later refinance for $375,000, using $50,000 of the $75,000 additional loan proceeds to improve your home and $25,000 to pay off credit card debt. If that $375,000 mortgage is later forgiven, only $350,000 may be excluded from income – the original mortgage indebtedness of $300,000 plus the $50,000 used to improve the home. The $25,000 of debt proceeds used to pay off credit cards will be taxable income.

Keep in mind that this exclusion only apples to mortgage debt on your main home. Your main home is the one that you live in most of the time. You can only have one main home at any one time. Cancellation of debt on second homes, rental and business property, car loans or credit card loans does not qualify for the exclusion.